December 04, 2008

Some unpleasant Keynesian arithmetic

How much of a boost to economic activity will a fiscal stimulus provide? For those who believe that we have entered a Keynesian world of shortage of aggregate demand--me included--the answer depends on the Keynesian multiplier. The size of this multiplier depends in turn on three things in particular, the marginal propensity to consume (c), the marginal tax rate (t), and the marginal propensity to import (m). If c=0.8, t=0.2, and m=0.2, the Keynesian multiplier is 1.8 (=1/(1-c(1-t)+m)). A $1 trillion fiscal stimulus would increase GDP by $1.8 trillion.

Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8. The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.

In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8). Yes, yes, import protection is inefficient and not a very neighborly thing to do--but should we really care if the alternative is significantly lower growth and higher unemployment? More to the point, will Obama and his advisers care?

Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here will produce an even larger current account deficit. If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3. How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the "gift to foreigners" that this represents? And they will have Keynesian logic on their side.

The way out of this dilemma is to get the rest of the world to engage in fiscal expansion at the same time--so that the gift is returned. The good news here is that China is playing along and hopefully the Europeans will too (if they can convince Germans to get over their weird obsession with fiscal conservatism).

But most developing nations are constrained by weak fiscal fundamentals. They cannot play the fiscal stimulus game because their borrowing capacity is limited: external finance is drying up and domestic financial markets cannot absorb the increase in public debt without a sharp rise in interest rates.

So unless we come up with a solution to the credit constraints in the developing world, we are going to either endanger the effectiveness of Keynesian policies in the U.S. and other advanced nations, or risk a sharp increase in protectionism. Not a pleasant choice.

Two solutions suggest themselves. One is to enlarge global liquidity by creating new SDR allocations and handing them over to developing nations to increase their spending. The other is to institute a Tobin tax on foreign currency transactions and pass the proceeds on to the developing nations.

Comments

The problem is not a world with a “shortage of aggregate demand” but a world with a shortage of aggregate trust. And I believe we will not be able to solve it in any Keynesian way before the world is convinced we are willing to pay for it!

Just as an example we have witnessed so many Congress debates where the motto has been “let us think about the taxpayer” but we have yet to hear one single word about the taxpayer paying something, on the contrary all they speak about there are tax rebates.

Of course, the current tax share of GDP in the US is closer to .15 than .2, and we have a negative savings rate, suggesting that the multiplier is a lot closer to 2.5 than 1.8, so its not so clear that this is an issue to get worked up about.

You dream. Exporters in developing countries, specially natural resource based exporters, have captured governments. They'll push for reduced spending with the stupid argument that tough times require less spending. Brasil and India are NOT going to go along with a coordinated fiscal expansion.

A massive increase in US borrowing should cause the dollar to fall - there must be some limit to the appetite for treasuries, esp. after the 'crisis' subsides a bit. That could be an equilibrating force in the opposite direction.

Fascinating how these debates of the late 1930s are returning. I learnt about them in the late 1960s from the
participants, pupils of Keynes. We had a (sort of) rerun of this debate in the 1970s.

I strongly with your policy recommendations which are even more important for the UK ... particularly if Germany continuees to resist domestic fiscal stimulus. But, given (as you have demonstrated) the strong effectiveness of low real exchange rates for growth and exports, what will China do both about domestic consumption stimulus and on its exchange rate?

One thing that intrigues me (as a an economic novice) is how energy investment (as seems likely) affects the whole situation. It is clear that a large portion of the value of money is in it's capturing and mediation of energy. So, a farmer who sows crops by hand is gaining extra value from seeds and soil through personal energy expended. Consequently the use of technology for the same tasks produces greater returns, while artificial energy costs are lower. The same story is true throughout the economy. In this way, cheap energy is a requirement of any modern economy, summing up, I would suggest, a large portion of what is valuable in money. The end of cheap fossil fuels necessitates new energy sources for this job, and would suggest that targeted investment may produce greater dividends. Perhaps I am wrong, but if so I would love someone to tell me why!

Nicely stated; unless the US solves the problem of the current account deficit, problems will continue. We will have a second default of american foreing debt (the first has been what we has just witnessed), this time default of sovereign debt. Becouse of this protectionims is going to be rampant. I suggest that the US introduces a VAT system of the order of 20-22% eliminating indirect state (consumption) taxes. Payroll taxes could (should) be reduced accordingly. Everybody knows this is equivalent to a hidden depreciation. In fact is much more; it is a dynamic depreciation. And foreign trader partners can not complaint or retaliate: this is what they do already. This will go a long way solving the structural american current account deficit. It works smoothly; Germany knows this very well as they succesfully improved this trick at the beginning of 2007. The British apparently not (they are reducing VAT now as a fiscal stimulus) to their own peril.
In Spain we will have to do the same, once our political leadership ends the long "siesta" and decides to do something.

Isn't this one of those "static" vs "dynamic" things? As in "holding everything else constant, the multiplier is f(t,c,m)". But by changing m, you change t and c so the actual multiplier effect is at best uncertain (and given what most economists believe about trade, probably negative).

I trust that the comments about raising import tariffs to boost the government spending multiplier are tongue-in-cheek. That was the reasoning behind the Smoot-Hawley Act of 1930, which went a long way toward reducing world trade by 70% between 1930 and 1933.

If the multiplier is small, then for a given ultimate effect the initial stimulus would need to be bigger.

But since incremental spending goes, in part, to buy imports, one might expect the dollar to depreciate (unless others are stimulating in concert with the US), and this would boost exports. Presto, the multipier effects, once this export boost is factored in, might actually be stronger than Dani's initial simple arithmetic suggests.

Ok, I'm confused. Why not just increase the deficit enough to fill the demand gap in this country, rather than try to reduce imports (exports are cost, imports are a benefit) and reduce our real standard of living? We are a sovereign currency issuer in a floating exchange rate world. There is absolutely nothing stopping us from maintaining internal demand at level we want, for as long as we want. If a $1T deficit isn't enough, take it to $2T. We really need to get over these mental limitations that apply the rules for a currency user to a currency issuer.

Indeed, our current times mimic the great depression so much, we need Hawley-Smoot II to go along with it!

It's not like all the money spent on imports would go right to American goods with everything else remaining the same. We would spend much more at Wal-mart and take away from American goods we purchase now. We get a lower standard of living and many industries would suffer. And this is before the reduction of exports after other countries react with higher tariffs of their own. Congratulations for one of the worst policy proposals by any economist, anywhere, in history.

What the multiplier does not take into account is the time lag that the US economy may have in transferring from a service economy to a manufacturing economy, in reference to the "m" component. At the beginning, prices will be high, due to supply shortages. In trying to keep inflation at low levels, high interest rates will reduce lending, which will in turn reduce supplies. Fiscal stimuli must be directed towards investment in order to compensate for high costs of debt. The demand side should not be stimulated, for it will only generate market distortion and future bubbles.

Yeah Jimbo
If $2T doesn't work print $3T and spend that. Additionally, if you don't want aggregate demand to diminish, just throw whatever you buy with the $3T into the Pacific ocean so demand will stay strong.
What could go wrong?

Did we ever figure out why (Keynesian) prices were fixed? Seemed like an ad hoc assumption used by well-meaning, but misguided do-gooders and money hose liberals to justify brutally inefficient government expansion to me.

However, I don't want to sound like a novice, but I never really quite bought the multiplier effect in Keynesian fashion in regards to increased government spending.

I mean, someone correct me if I'm wrong, if we are to depend on the government being the agent of the multiplier and the private market is supposed to create more wealth than the government, by one hundred fold. Then, how can it be that with mere increases in government spending to raise aggregate demand, would Keynesianism under the multiplier rationale work under the conventional idea that government intervention made it all possible? Also, taxes, which are derived from persons with wealth and money to spend, make for a better situation?

But, I guess an argument for the "KME" could be that we are in the deflationary period of the crisis. And, increases in government spending to increase purchasing power are a likely desired outcome--boosting demand and raising prices. Or, even more simply-especially if government prints money to get the work done, assuming that a considerable amount of private wealth is lost-then you may have a case. But, it’s not the case you would want to make, by making it a known fact that your money is worthless.

Perhaps government too credit for it too quickly. Perhaps it is really what it is, a psychological fear to spend in the market--then and now.

We would have to depend on the private market at some time, I reckon, if we follow the Keynesian effect straight through to its logical conclusion.

My thing is now, how do we get straight to the core and boost confidence? This seems more the rational and narrative I would like and expect to see played out by government’s world wide.

For example, how Bernanke sacrificed inflation by cutting rates to boost productivity. He was way off in his educated gamble. But, he had to act--or at least, so they say!

Even more direct and relevant to today's issue; the abuse of half of the $700 billion bail out package. Government officials acted like a Keynesian would.

What happened? Under both Paulson and Bernanke's efforts? The private market still did what it wanted and the market is still wrought with fear, to spend and to extend credit.

There has to be a better, more reasoned answer than KME or bail-out, by themselves.

I don't see best and end all scenarios to that particular part of Keynesianism--and I, for one, subscribe to the principles--to some extent-- at times of trouble. Govt. deficit on one side and/or weakened monetary power on another are things which are unavoidable. But, you need to pick your poison--this is the way I see it.

umm hey, there is a very simple solution to this, it is not some sort of ultra-complex conundrum. To prevent long term mercantilist policies and structural imbalances on the other side of the equation one should link all currencies to something of fixed or relatively fixed size. Conveniently enough, the central banks all have lots of this gold stuff still in their vaults, and thats why it was there in the first place. We could try to reinvent the wheel in our super neo-economic brilliance, hoping to figure out something new and super improved, or we could just link all of the currencies to gold again and get it over with, because thats what has to happen to force countries to have fair long term exchange rates. No gold = messed up relative exchange rates and long term imbalances. Gold prevents this. So go ahead and reinvent the wheel. Or just use a %$#@$% wheel that we already know works. Gold. This is not rocket science, people.

and credit constraints are the problem? no, abundance of mispriced credit (cheap money) is the problem. The cure for too much debt is unlikely to be more debt. Maybe, but highly unlikely. A gold backed currency will necessitate higher interest rates encouraging savings and thus slowly lowering the cost of credit based upon real existing resources rather than false signals from arbitrary central bank guesstimates of the proper price of money at a given time.

The dollar has to fall to increase us exports, the asian currencies must rise to increase their consumption. Gold will force this adjustment, new fangled scientific formulas, plans, systems, techniques base on evolving understandings are fun in theory but unlikely to actually work.

We spent too much, we save too little, the lack of demand is a result of the oversupply of consumption goods based on easy credit which encouraged higd debt loads. More debt wont solve this. Less debt, more savings and a return to a more balanced economy based more on production and less on consumption will. Why does everyone want to reinvent the wheel?

I've not seen anyone else comment about the impact of VAT taxes, and particualrly, the impact of most of the rest of the world relying on significant VAT taxes while the US has nothing but relatively small state sales taxes.

Is it not correct that most VAT taxes exempt exports, and tax imports?

Why not finance a single payer health care plan with a VAT tax.

This could:

- Tax imports on a level playing field with the rest of the world, helping to solve the trade deficit gap.

- Boost exports, on a level playing field with the rest of the world.

- Help shore up Medicare and Medicaid.

- Help solve the legacy health care issues for auto makers and other aging giants stuck in a pension bind.

- All without being labeled as protectionist.

- To make it even more favorable and explicit, we could exempt services, as many states do on their sales taxes.

- Could be ramped up by 1% per year for say 10 years, and that timing would help counterbalance the demographic shift coming.

The monetary base has been exploded. It's easy to do with a fiat currency. Lowering interest rates is pointless, the target rate is like 1% and the market rate is like less than .5%. Intermediating institutions aren't lending becasue they are deleveraging. The government is forcing the abrogation of mortage contracts, this is socialism. We are now a banana republic and hyperinflation is next. I tire of idealogues who lack business experience. If I were a younger man, I would seriously consider emmigrating.

US will eventually default, and in return, the rest of the world will lay claim to intellectual property owned by US companies as compensation. So, that any innovation/technology advantage the US had will be wiped out. US will become debt free and the rest of the world will be a better place as they will no longer have to pay rent to US companies for past innovation. Innovation that US companies feel they have a right to own forever and on which to collect a fee. As if, because they thought of it first, it's their's and only theirs. Nobody else would ever have thought of it if the US had not done so. Intellectual property rights have been somewhat respected upto now because that was the only way of getting access to the US consumer, which every other country wanted to do, but that has now run its course.

Assuming that we "pay" for the stimulus by printing the money, won't we see a devaluation that will make imports more expensive and act as a tariff for purposes of the multiplier? This is another sort of 'beggar they neighbor' policy from the 1930s, but what other option do we have?

The only way long term American trade deficits can be balanced out is by American trade surpluses and/or by the type of involuntary debt forgiveness that comes with depreciation of the UD$.

Those that gave us unsustainable trade credit should not be surprised or feel too badly treated. They have only gained on the trade up to now and if they end up with a haircut on the debt they will still be net ahead on the deal.

Obama's advisers were authors and benificiaries of the present globlisation in the Clinton era and prior. They are representatives of owners, or partial owners themselves of those who partially own production in China and other developing economies. In the past developing economies were loaned money, but starting in the 90s they were instead given technlogy and money for partial ownership, which is why those in charge were willing to ship US manufacturing jobs to China. US citizens were forced to swap jobs for debt and it will be no surprise to me if they are now forced to swap whatever other assets our country has that can be securitized or otherwise monetized for even more debt on US citizens so that factories overseas, partially owned by US individuals and enterprises, can begin profitably producing product for developing consumers.

Or we could get the same demand bump by borrowing $1.6 trillion instead of one -- assuming that the recessionary gap is indeed $2.8T.

Put that extra 1/2 trillion (~5% of current debt) against a hit on poor countries, less of the joys of their imports, likely retaliation that could kill the WTO (Smoot Hawley II?)... I'd rather do the extra borrowing. We can inflate the debt down if we must. To exaggerate the already severe problems stemming from extreme fluctuation of poor country exports should be the last resort.

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i like this part of the post:Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8. The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.

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Nice post, Dani. You're suggesting that developing nations are the answer to this... I think African markets will experience the most growth in the next 50 years because of technology growth and cheap labor. Northern Africa is the next India for low cost labor. We already know that cctv cameras and some bucket trucks are being manufactured, produced, and sold overseas from North African companies.

Exporters in developing countries, specially natural resource based exporters, have captured governments. They'll push for reduced spending with the stupid argument that tough times require less spending. Brasil and India are NOT going to go along with a coordinated fiscal expansion.